A dividend reinvestment plan for stock dividends provides an automatic path to compound growth of your stock investment. The challenge of dividend reinvestment is to keep track of the reinvestment amounts and the potential tax consequences of all of those reinvestment amounts. The basic tax rules for stock investing, however, continue to apply.
You pay taxes each year on the dividends you earn through the stock dividend reinvestment plan. At the end of the year, you will receive a Form 1099-DIV listing the amount of dividends you earned for the year. You include this money in your taxable income for the year, even though the dividends have been reinvested into more shares. This means the money used to buy shares with reinvested dividends has already been taxed once.
Your cost basis on any of the stock shares in your dividend reinvestment account is the price you paid for the shares. It does not matter how the shares were purchased -- that is, whether you sent in a check or paid with reinvested dividends. When a dividend is used to purchase shares, you will receive notification of how many shares were purchased with the dividend and the cost of the shares purchased with the dividend.
If you sell shares out of your dividend reinvestment plan, you owe capital gains tax on any profits earned from the sale. The profit -- capital gain -- is the difference between the sales price and the price you paid for the shares. When you sell shares purchased with reinvested dividends, you will owe capital gains tax on the amount the shares have increased in value since they were purchased with the dividends. You do not pay capital gains taxes on the dividend amount used to buy the shares.
When you sell shares from your dividend reinvestment plan account, you must report the purchase price and sales price of the shares sold. Since you have made a number of purchases as the dividends reinvested, you should keep accurate records of purchase dates, prices and number of shares bought. The gains on shares owned for more than one year will qualify for lower, long-term capital gains tax rates. Profits on shares owned for one year or less are classified as short-term gains and taxed at your regular income tax rate.